BUILDING TOMORROW™ Macro Credit Research Bloomberg Coco Bond Symposium, Coconomics March 2015 Alberto Gallo, CFA Head of European Europe’s old banking system and its new capital Macro Credit Research +44 (0) 20 7085 5736 [email protected] Lee Tyrrell-Hendry Macro Credit Analyst +44 (0) 20 7085 9462 [email protected]
Mateja Popovic Macro Credit Analyst +44 (0) 20 7085 9698 [email protected]
Tao Pan Macro Credit Analyst +44 (0) 20 7678 3122 [email protected]
Ashleigh Grant Macro Credit Analyst +44 (0) 20 7678 6494 [email protected]
Gaurav Chhapia Apurv Chaudhari
Produced by The Royal Bank of Scotland plc. In the UK, the Royal Bank of Scotland plc is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct rbs.com/cib Authority and the Prudential Regulation Authority. The credit supercycle: What next? Asset bubbles or deflation?
$tn US GDP 70 US credit market debt European credit market debt
Financial crisis 60 Competition & credit control Big Bang (UK) Glass-Steagall Act repealed Quantitative introduced / Bretton Woods easing breaks down
50 Asset bubbles
40
Deflation?
30
You are here 20
10
0 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14
Source: RBS Credit Strategy, ECB, FRED, Bloomberg
2 Deeper capital markets helped the US restructure debt more quickly
US private sector delevered US took losses in capital markets, Europe in banks Debt as % of GDP Default losses since the crisis as % of GDP
Cumulative loan losses, including increase in NPLs 7% Cumulative MBS losses 450% Government Household Corporate Bank Cumulative bond losses 400% 6%
350% 5% 300% 4% 250% 1.9%
200% 3% 5.5% 0.3% 150% 2% 100% 2.6% 50% 1%
0% 0.3% Eurozone Eurozone US US 0% US Eurozone 2008 Now 2008 Now
Source: RBS Credit Strategy, OECD, Eurostat, ECB, Federal Reserve, Markit Source: RBS Credit Strategy, Moody’s, ECB, Federal Reserve, Fannie Mae, Freddie Mac
3 Public and private debt overhangs still standing Total debt by segment of the economy, % GDP
800% Banks 700% Corporate Household 600% Government
500%
400%
300%
200%
100%
0% IE DK NL PT SE FR UK ES BE EA IT US FI AT GR DE SI
Source: RBS Credit Strategy, OECD, Eurostat, ECB, Federal Reserve, Markit
4 Transforming the banking system
5 European banks: Largest in the World Bank asset size / GDP
700% Bank assets % GDP 10-years ago
600%
500%
400%
300%
200%
100%
0%
UK US
Italy
Spain
GIIPS
Japan
Ireland
France
Austria
Cyprus
Finland
Norway
Canada
Sweden
Slovenia
Australia
Denmark Germany
Euro Area Euro Switzerland Source: RBS Credit Strategy, ECB, IMF, RBA, BoJ, US Fed, BoE
Source: RBS Credit Strategy, ECB, IMF, RBA, BoJ, US Fed, BoE Europe’s financial system relies too much on banks Outstanding credit, % of GDP
US EA 120% 106% 100%
80% 74% 68% 60% 48% 52% 46% 44% 40% 29% 22% 18% 20% 16% 9% 9% 7% 5% 6% 0% 3% 0% Bank Agency Government Municipal Corp & bank Covered MM MBS ABS loans loans bonds bonds bonds bonds
Source: RBS Credit Strategy, ECB, Federal Reserve, SIFMA, BoAML indices, Bloomberg, IMF, FSB
7 Banking systems: Euro area vs US Euro area US 5,557 - Number of banks - 5,783
3.1x - Bank assets/GDP - 0.8x
37 - Number of branches - 35 per 100,000 adults
22% - Bonds/total debt - 52%
16% - Mkt share of top 5 banks - 33%
€1,010bn - NPLs - $182bn
10.5% - NPLs/GDP - 1.2% Source: RBS Credit Strategy, Bank of Italy, ECB, IMF, World Bank, FRED 8
More stress after the tests: Many European banks are still weak Results of the ECB-EBA stress tests
44% of banks failed or passed narrowly Austria, UK and Germany have more narrow passes % by number and by total EU banking assets Assets as % of total banking system assets in the country
Fail Fail Pass narrowly Pass 20% 100% (3% by total 90% assets) 80% 70% 25 60% 50% 40% Pass 30% 56% 69 29 20% (77% by total assets) Narrow pass 10% 24% 0%
(20% by total UK
assets) Italy
Malta
Spain
Latvia
Ireland
France
Austria Poland
Cyprus
Greece Finland
Norway
Sweden
Belgium
Portugal
Hungary
Slovenia
Germany Denmark
Netherlands Luxembourg
Source: RBS Credit Strategy, ECB Source: RBS Credit Strategy, ECB
9 Deleveraging has stabilised, but bank lending is weak Monthly decline in total loans to non-financial corporations between Jan 2009 and Jan 2015, €bn
0
-100
-200
-300
-400
-500 Stabilisation?
-600
-580bn -700 2009 2010 2011 2012 2013 2014 Total
Source: ECB, RBS Credit Strategy 10 Bank capital is near a 200-year low Book value of equity / total assets for US banks
70%
60%
50%
40%
30%
20%
10%
0% 1834 1844 1854 1864 1874 1884 1894 1904 1914 1924 1934 1944 1954 1964 1974 1984 1994 2004
Source: RBS Credit Strategy, FDIC, Historical Statistics of America 11 Too big to fail has not gone away Bank asset size / GDP
200% 180% 160% 140% 120% 100% 80% 60% 40% 20%
0%
CS DB
Citi GS
MS
JPM
RZB
SEB BES
UBS BNP KBC BAC
HSBC
Danske
SocGen
Barclays
Unicredit
Credit Ag Credit
ING Bank ING
Rabobank Santander
Source: RBS Credit Strategy, Bloomberg, company filings 12 Profitability is chronically low
RoE for European banks has not fully recovered NIM has been consistently lower for European banks
20% Europe RoE US RoE 5% Europe NIM US NIM 18%
16% 4%
14%
12% 3%
10%
8% 2%
6%
4% 1%
2%
0% 0% 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2001 2003 2005 2007 2009 2011 2013
Source: RBS Credit Strategy, Bloomberg Source: RBS Credit Strategy, Bloomberg
13 Costs are still high Number of branches per 1,000 people, Italy
80
70
60
50
40
30
20
10
0 Museums High schools Secondary Primary Pharmacies Kindergartens Hotels Bank schools schools branches
Source: RBS Credit Strategy, OECD, Istat 14 Interconnectedness: Cross-holdings in Europe’s banking system
Italy 77.7% Fondo 4.5% 2.57% Strategico 9.42% 100% Qatar Iberdrola Toro Generali
1.3% 0.07% 9.88% 1.4% 12.2% Abu Dhabi Libya Veolia Intesa 6.43% 2.6% 6.44% Monte 5% BlackRock 4.9% 8.7% Groupama Mediobanca UniCredit
0.10% Germany 2.45% France 2.51% 3.4% 2.27% SocGen Credit Agricole Mediolanum 17% Allianz 0.52% 2.28% Portugal AXA 0.52% 0.01% Telecom 0.34% Natixis AM POP 0.1% Deutsche Bank Commerzbank 0.16% BBVA 0.6% 1.21% Caixa Geral 3.65% 0.19% 4.92% 2.8% 5.75% 1.7% Credit 4% 3.15% 0.22% UBS CRH BNP Santander Suisse Caixa Telefonica Holdings 3.26% 6.4% 5.6% 2.81% 1.18% 0.15% 0.14% 34.6% 11.6% Norway Singapore Gas Natural Caixabank Repsol Bankinter State Street
Source: RBS Credit Strategy, Bloomberg, company filings. Red = bank, Grey = sovereign, Blue = other 15 Capitalism without capital: The RWA optimisation arbitrage Large banks have optimised risk weights, but absolute capital levels remain low
RWA % total 100% 90% 80% 70%
60% BBVA 50% UniCredit Intesa Santander HSBC 40% Rabo ING Lloyds BPCE Barclays BNP 30% CS LBBW ABN Danske Credit Ag 20% UBS Soc Gen Deka Nwide SEB DZ Nordea DB SH Natixis 10% Pohjola 0% 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000 Balance sheet size, EUR bn
Source: RBS Credit Strategy, Bloomberg 16 The economics of a TLTRO loan Example: a local periphery bank
50 Loan yield = 4.5% TLTRO cost = 0.05% 45
40 4.5% default rate, 40% recovery 35 SME loan RWA is 75% (8% capital charge)
30
1,000 loan loan 1,000 € 25 Normal funding Savings Returns on SME 20 cost = 2% = 1.85% lending are still low even w ith
Based on a a on Based 15 cheap funding
10 0.5% cost 0.5% return 5
0 Gross interest Normal TLTRO Cost of capital Cost of Operating Net economic income funding costs savings on loans provisions costs profit
Source: RBS Credit Strategy
17 Assets: Bad loans still rising in the periphery, stable in core Europe NPL ratios are increasing in Greece, Ireland, Italy, Portugal and Spain
Periphery NPL ratios are still rising NPLs remain low in core Europe NPL ratio, % of total loans* NPL ratio, % of total loans
35% 8% UK Greece France Italy 7% Germany 30% Spain Netherlands Portugal 6% 25% Ireland Belgium 5% 20% 4% 15% 3% 10% 2%
5% 1%
0% 0% 07 08 09 10 11 12 13 14 07 08 09 10 11 12 13 14
Source: RBS Credit Strategy, Bloomberg, Banco de Espana Source: RBS Credit Strategy, Bloomberg
*The recent decline in Spanish NPLs is partly due to SAREB, which has taken over €50bn of assets off bank balance sheets. For Ireland, we use mortgage arrears/ total loans, which will be lower than total NPL levels 18 Assets: The sovereign-bank nexus is getting stronger Sovereign exposure is a multiple of equity
Mid-tier banks have the most periphery sovereign debt Italian, Spanish and Portuguese increase their holdings Bank sovereign holdings at the end of 2013, % total assets Aggregate MFI holdings of sovereigns, % of total assets
18% Spain Portugal Italy Ireland Greece 12% Ireland Spain Italy Portugal Greece 16% 14% 10% 12% 8% 10% 8% 6% 6% 4% 4% 2%
0% 2%
BPI
UBI
BCP
Intesa BBVA
Monte Bankia
Popular 0%
Popolare
UniCredit
Santander CaixaBank
Caixa Geral Caixa 2008 2009 2010 2011 2012 2013 2014
Source: RBS Credit Strategy estimates, EBA Source: RBS Credit Strategy, ECB
19 Designing a resilient financial system
20 Capital: 3% is not enough 3% of capital will be insufficient to cover asset losses in a crisis
Bank losses in previous crises European banks are generally between 3-4% capital Losses as % of loans and assets Leverage ratio, Q4 2013
20% Losses as % initial loans Losses as % initial assets 6% Leverage ratio 15% 5%
4% 10% 3%
2% 5% 1%
0% 0%
CS DB
ML
BoI
AIB
UBS ABN BNP KBC
B&B
SNS UBS
NBG
Dexia
Anglo
BBVA
Wach
Intesa
Amag Nrock
CMZB
Monte
Lloyds
HBOS
WaMu
Bankia
Nordea
SocGen
Barclays
UniCredit
INGBank
Rabobank
Santander CreditAg Group
Source: RBS Credit Strategy, Bloomberg, Company filings Source: RBS Credit Strategy, Company filings. Using our estimates for Intesa
21 How much capital is enough? A formula for financial stability
Crisis bank size of =[ - ( capital + bail-in + backstops )] x cost losses system
banks lost €55bn 3% 8% of 3x GDP 2%-13% of leverage ratio total liabilities SRM fund total assets in previous crises
= 5.8% capital / assets
Source: RBS Credit Strategy, BBG, Company filings 22 Bail-in: Some capital structures still vulnerable to 8% threshold Capital structure of banks, black line = 8% of total liabilities*
60%
50%
40%
30%
20%
10%
0%
DB
IKB
UBI SID
LBB
BFA NLB
BES SEB
BNP KBC BCP SHB
HSH
NBG
Tatra
Erste
BKIR
WGZ NWB
Alpha
Intesa
BBVA Iccrea Monte
BCEE
Aareal
Lloyds HSBC
CMZB
Carige LBWF
CXGD NKBM
Natixis LBBW
Bawag Bankia
Belfius
Veneto Helaba
BPEIM
Nordea
Pohjola
Abanka
Danske Piraeus
Popular Sondrio
Argenta
Ibercaja
SocGen
Nord LB Nord
Barclays Sabadell
DZ Bank DZ Popolare
Cred Em Cred Unicredit
Hypo RE Hypo
ApoBank
DNBNor
Bankinter
Eurobank
BayernLB Liberbank
INGBank
Catalunya
Raiffeisen
Rabobank
BP Milano BP Slovenská
Santander DekaBank
Allied Irish Allied Caixabank Swedbank Cariparma
Kutxabank Bank SNS
C. Espana C.
Banco BPI Banco
Bd Marche Bd
Nationwide
Perm. TSB Perm.
Valtellinese France BPI
CredAg SA CredAg BPCE Grp.
BP Vicenza BP
M.Nostrum
Rentenbank
Mediobanca
NCGBanco
ABN AMROABN
Bk of Cyprus Bkof
Munich Hypo Munich
Crédit Mutuel Crédit Hellenic Bank Hellenic
More equity and sub Lux Int Banque Less equity and sub Equity (min. of market cap and book value) Subordinated Senior unsecured Deposits Secured
Source: RBS Credit Strategy, Bloomberg, company filings. Note banks can bail-in 8% of total liabilities or under special circumstances 20% of RWAs (where the ex-ante contributions were 3%) before accessing national resolution funds. For banks for which no market cap is available, we have approximated taking the avg price-to-book across comparable banks. For Greek banks we have used market cap, as the book value was unavailable.
*calculated as a proportion of the sum of equity (market cap), sub, senior, deposits and covered bonds. The calculation excludes derivatives as the final treatment of the valuation of derivatives for the purpose of bail-in has not been determined yet. 23 Capital: Quality of capital will count more in the future National regulators could impose equity thresholds or limit coco capital
Spanish banks have relatively smaller buffer of sub A large part of Spanish bank capital is made up of DTAs Capital ratios, % RWAs DTAs, % of Core Tier 1 equity (Spanish banks in red)
80%
20% 70% CT1 (%) Govt Support (%) DTA (%) T1 (%) T2 (%) 60%
15% 50%
40% 10% 30%
20% 5% 10%
0% 0%
DB BCP
BNP -10%
Caixa
Intesa BBVA
Monte
Lloyds
CXGD
Bankia
Popular
Group
SocGen
Barclays
Sabadell
Unicredit
Credit Ag Credit
BPI
Santander
Banco BPI Banco
SEB
BCP KBC BNP RBS SHB
DNB
Erste
Rabo
Caixa Dexia
Intesa BBVA
Monte
HSBC
CMZB
Lloyds
CXGD
Bankia
Nordea
Danske
Commerzbank
Popular
SocGen
Barclays
Sabadell
Unicredit
Bankinter
C. Ag Grp Ag C. Santander
Source: RBS Credit Strategy, Bloomberg, company filings Source: RBS Credit Strategy, Bloomberg, company filings
24 TLAC: More loss-absorbing capital, but penalises lenders vs IBs
European banks need to issue more sub debt for TLAC TLAC favours big banks with low RWA intensity TLAC as % of total assets TLAC as % of total assets**
30% Equity & sub as % of RWA 14%
25% 12% 21-25% 10% 20% TLAC may not be enough for 8% bail-in 8% 15% 6% 10% 4%
5% 2%
0% 0%
DB
DB
ING
ING
CS*
UBS BNP
BNP
UBS*
BBVA
BPCE
BBVA
HSBC
BPCE
HSBC
Nordea
Nordea
SocGen
Cred Ag Cred
SocGen
Barclays
Barclays
UniCredit
UniCredit
Credit Ag Ag Credit
StanChart
Credit Ag Ag Credit
StanChart
Santander Santander
Source: RBS Credit Strategy, Bloomberg Source: RBS Credit Strategy, Bloomberg. *Swiss banks not directly subject to EU BRRD. **Calculated based on 25% of RWAs or 6% of assets
25 Reforms and consolidation pay off Banks in pro-reform countries trade at better P/B multiples and at lower spreads
Comprehensive restructuring Price-to-book ratio Minimal restructuring
1.4x CDS spreads (RHS) 400
1.2x 350
300 1.0x 250 0.8x 200 0.6x 150 0.4x 100
0.2x 50
0.0x 0 Ireland US Spain Eurozone France UK Italy Germany Portugal
Source: ECB, RBS Credit Strategy estimates
26 Facilitating NPL disposals: The foreclosure process
It takes nearly 5 years to foreclose in Italy A lengthy judicial process discourages investment Typical duration of a foreclosure procedure, years IRR decreases with longer foreclosure period
5 IRR 50%
4 40%
3 Spain 30% Germany France 2 Portugal Greece 20%
1 Italy 10% 0
Italy 0%
Spain
F rance Austria Greece
Belgium 1 2 3 4 5
Portugal Germany
Years to foreclose
Netherlands Luxembourg
Source: RBS Credit Strategy, ECB Source: RBS Credit Strategy; IRRs are calculated based on a hypothetical bad loan investment, assuming €100m face value with 50% hair-cut for purchase price and 70% recovery rate
27 Non-bank lending & ABS: A Better Solution for Europe European securitisations outstanding, €bn
350 ABS CLO CMBS RMBS
300
250
200
150
100
50
0 UK Holland Italy Spain Germany France Other Europe
Source: RBS
28 Non-bank sources could help to close Europe’s lending gap Decline in NFC loans since crisis (€bn), and potential offsetting effect from non-bank & TLTRO lending
0
+265 -100 -90
-200
-300 +20 +5 +50 -400 +60
+50 -500 +40
-600 -580 Decline in Growth in New CLOs EIB lending Non-bank Private Crowdfunding TLTRO Net financing NFC loans HY bonds lending Placements gap
Source: RBS Credit Strategy, ECB
29 Contingent capital to the rescue…
Source: FT Alphaville 30 Cocos add capital, bail-inable securities Large banks capital as % of assets
7% LT2 6% Cocos (T2) AT1 5% CET1
4%
3%
2%
1%
0%
CS
ABN BNP UBS
BBVA
Intesa
CMZB
Lloyds* Nordea
Danske
SocGen
ING Grp ING
Barclays
Unicredit
KBC Grp KBC
Deutsche
Rabobank
Santander Credit Ag Grp Ag Credit
Source: RBS Credit Strategy, Bloomberg, Company filings, Note: Phase-in data has been used and where not available fully-loaded *Includes ECN 31 A yield trade, with high tail risk Why are you buying cocos?
80%
60%
40%
20%
0% Yield Conversion is unlikely Lack of alternatives Cheap vs risks
Source: RBS Credit Strategy. Based on responses to the RBS Coco Survey, 2014 32 Not all risks are priced in
A dislocated market: Coco spread vs distance to trigger Coco-senior spread vs distance between capital ratio and conversion trigger
Undervalued 6% POPSM 11.5 SAN 6.25 BACR 8 BBVA 7 5% SOCGEN 7.875 BBVA 9 DANSKE 5.75 UCGIM 9.375 NWIDE 6.875 BACR 8.25 SOCGEN 8.25 4% ACAFP 7.875 CS 7.5
3% BACR 7.625 BKIR 10 ACAFP 8.125 RABOBK 8.4 CS 7.875 2% CS 5.75 UBS 4.75 (2014) UBS 7.625 Cocospread oversenior BACR 7.75 CS 6.5 RABOBK 8.375 ISPIM 9.5 1% UBS 7.25 KBC 8 Overvalued 0% 0% 2% 4% 6% 8% 10% 12% 14% Distance to trigger
Source: RBS Credit Strategy, Bloomberg 33 A yield trade, with high tail risk How do you think the whole market will react to a conversion?
% answers 70 Avg expected drop: -15%
60
50
40 But high tail risk 30
20
10
0 0 -2 -4 -6 -8 -10 -12 -14 -16 -18 -20 Coco market price drop following a conversion event
Source: RBS Credit Strategy. Based on responses to the RBS Coco Survey, 2014 34 What could possibly go wrong? 90% of investors think they understand cocos better than the market How do you rate the market’s understanding of cocos vs your own? (1 = very bad, 10 = very good)
8 My knowledge Market knowledge
6
4
2
0 Hedge fund Asset manager Private banking Insurance Pension fund
Source: RBS Credit Strategy. Based on responses to the RBS Coco Survey, 2014 35 Coconomics: Understanding cancellation and conversion risk Tail risk events like big trading losses or fines can push up conversion or cancellation risk
Probability 20% Conversion trigger (7%) Coupon deferral trigger (8.5%)
15%
10%
5% Tail risk scenarios
0% ≤4% 6% 8% 10% 12% 14% 16% >18% CET1 ratio after five years
Source: RBS Credit Strategy 36 Allocation: After the melt-up, investing without getting swallowed
Source: Google images 37 Asset managers face pressure as yield decline, fees stay the same Some respond with lower fees, most hunt for more yield
12% 10y Bund yield Asset Manager fees 10%
8%
6%
4%
2%
0% 1956 1964 1972 1980 1988 1996 2004 2012
Source: RBS Credit Strategy, FRED, Bloomberg 38 The end of the beta trade? Stylised efficient frontier
Expected return 14%
12% Pre-crisis: leveraged high- rated portfolios (e.g. synthetic 10% CDOs, CPDOs) Today: investors buy unlevered, high 8% risk assets (e.g. HY, cocos) 6% QE effect
4%
2%
0% 0% 5% 10% 15% 20% 25% 30%
Volatility
Source: RBS Credit Strategy 39 Tier 1 issuance is accelerating Coco issuance volumes, €bn
140 Tier 2 Tier 1
120
100
80
60
40
20
0 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14
Source: RBS Credit Strategy, Bloomberg 40 But supply is nothing compared to ECB QE Euro bond market outstanding, €tn
14
12 ECB Sovereign QE Forecast IG Sovereign ECB sovereign QE HY 10 (€60bn/month) IG Corporates IG Financials 8 Cocos ABS 6 Covered bonds
4
2
0 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: RBS Credit Strategy, BoAML indices
41 Valuations: There is little juice left in risk premia anywhere
3,000 LT average 120 Current 2,500 Max 100 Min 2,000 80
1,500 60
1,000 40
500 20
0 $ IG € IG EM IG $ HY € HY EM HY 10y 10y 10y 10y V2X VIX P/E UST Bunds SPGBs BTPs
Source: RBS Credit Strategy, FRED, Bloomberg. 42 QE + lack of alternatives = I’m in love with the Coco! High beta credit has outperformed in 2015, total returns, 100 = 31 Dec 2013
120 Euro IG US IG Euro B US CCC Cocos Hybrids US HY UK IG EM $ Corp EM € Corp 115
110
105
100
95
90
85 Jan 2014 Mar 2014 May 2014 Jul 2014 Sep 2014 Nov 2014 Jan 2015
Source: RBS Credit Strategy, BoAML indices 43 Top returns in 2015 High beta credit has outperformed in 2015, total returns 2015, 100 = 31 Dec 2014
6% 5.5%
5% 4.5%
4% 3.8% 3.8% 3.7%
3.1% 3% 2.8% 2.3% 1.9% 2% 1.3% 0.9% 1% 0.8% 0.2% 0% Italy Euro B Corp Spain Coco EM Germany UK IG US HY Euro IGEM Corp US IG EM Hybrids € Corp $ Corp
44 Still among the best-yielding assets Less liquid and peripheral assets offer an additional premium
8%
$ B (511) 7%
6% € EM Corp (23) Cocos (123) $ BB (601) £ HY (77) Lev Loans (380) 5% € B (88) Hy brids (55) 4% $ IG (4888)
CLO A (70) Periphery HY (171) 3% £ IG (624) Yankee (2555) € Sub Fin (137) € BB (219) 2% Spanish regions (34) 1% € IG (1728) Periphery BBB (57)
0% 5 A6 7 8 BBB9 10 11 BB12 13 14 15B 16
Source: RBS Credit Strategy, Bloomberg, iBoxx, BoAML indices 45 But beware: Trading liquidity is low RBS Liquid-o-Meter: based on trading volumes, dealer inventories and bid-ask spreads, 100= Dec 2006
160 US Treasuries US corporate bonds
140
120
100
80
60
40
20
0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: RBS Credit Strategy, Bloomberg, SIFMA, MarketAxess, Federal Reserve Bank of New York 46 Some conversion and cancellation risks are mispriced
Conversion and coupon cancellation probabilities
Probability of >1 cancellation in 5 years 15% Low earnings volatility, weak capital High earnings volatility, weak capital
HSBC 10% KBC Barclays Nordea BBVA UniCredit Intesa Credit Ag Group Credit Suisse 5% Danske Nationwide SocGen Lloyds UBS DB Santander Low earnings volatility, strong capital High earnings volatility, strong capital 0% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Probability of conversion in 5 years
Source: RBS Credit Strategy; based on model estimates for a 7% conversion trigger and an 8.5% cancellation threshold 47 Conclusions: Cocos are still a good trade, but choose very carefully
1. Europe’s banks are transforming themselves from a social/government-supported model to one where all banks need to stand on their own feet. 2. Contingent capital instruments will grow in size, but without standardisation and without trading liquidity, they will remain volatile and subject to cliff risk. The coco market is not correctly pricing the volatility of business models. 3. Are cocos the solution for Europe’s financial system? In short, no. A lot more consolidation and more capital are needed, and business models need to change. But less and stronger banks could be good for coco risk. Prefer CBs to IBs.
Source: Google images, Wikipedia 48 Bibliography
Further research and reading The Revolver | Coconomics: Pricing contingent capital risks, 3 July 2014 The Revolver | Cocos: Investors call for standardisation, more consistency, 12 May 2014 The Revolver | Coco Loco: The systemic risks of contingent capital, 14 April 2014 Financial Stability Report, Bank of England, December 2014
Regulators must act on coco bond risks, 7 May 2014, Financial Times
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